It could have been so much worse.
Through most of a grim bear market, a spate of mutual fund scandals and -- not a moment too soon -- the 2003'04 equity comeback, the U.S. money management industry has remained remarkably profitable. During the four years through 2004, its average operating margin hovered between a low of 25 percent in 2002 and a high of 28 percent last year.
But a McKinsey & Co. report on asset managers, produced in conjunction with the Institutional Investor Institute, tells a decidedly cautionary tale. The study, which tracked the performance of more than 60 big and small firms that collectively manage more than $5 trillion in assets, concludes that the industry faces serious threats to its bottom line. Chief among them: slowing fund inflows, eroding pricing power and falling productivity.
Which money managers are best positioned to prevail in this competitive environment? The consultants identify three types of industry leaders: behemoths, which McKinsey describes as "at-scale competitors"; multiboutiques; and focused-asset providers.
"More and more, these winners are pulling away from the pack," says David Hunt, a McKinsey partner and co-author of the report.
In analyzing the threats to the industry, the consultants found that the already-slowing growth of inflows reflects the fact that traditional asset managers are losing ground to alternative players, with traditional managers' share of new inflows falling from 93 percent to 78 percent between 2001 and 2004. Hedge funds are claiming much of the turf, accounting for 13 percent of new inflows last year, up from just 2 percent in 2002.
Pricing is under pressure industrywide, but it's especially acute for retail firms. Net revenue yields for retail firms shrank from 59 basis points in 2001 to 51 basis points in 2004. Though institutional net revenue yields rose slightly over the period, from 33 basis points to 35 basis points, in the past year some categories have faced serious price erosion. Net revenue yields for midcap equity portfolios, for example, declined from 57 basis points in 2003 to 53 basis points last year.
Although assets have grown with the market's recovery, head counts have risen at a faster clip. As a result, productivity, as measured by assets under management per employee and adjusted for market appreciation, fell by more than 4 percent between 2001 and 2004, from $167 million to $160 million.
Firms pursuing McKinsey's three winning strategies are, on average, nearly twice as profitable as their industry peers, termed "stuck-in-the-middle" players by McKinsey, neither large nor focused. The winners deliver an average operating margin of 34 percent or more, versus 18 percent for their midsize brethren.
"We were quite surprised by how dramatic the difference in margins turned out to be," says Hunt.
At-scale competitors, which report at least $100 billion under management, delivered margins of 34 percent last year. Multiboutiques, reporting margins of 36 percent in 2004, offer diversification across investment styles as well as scale within certain asset classes. Focused-asset providers, with at least two thirds of their assets in either fixed income or equity, produced margins of 34 percent last year. Focused firms' earnings, though, tend to be volatile, rising or falling when their dominant asset class is in or out of favor.
Even among money managers pursuing one of the winning strategies, there were wide discrepancies in profitability. For example, the most profitable at-scale competitors generated average margins of 45 percent in 2004 -- double those of the least profitable.
Smart strategic execution separates the stars from the merely so-so. Often that means deploying effective client service to retain assets. (Interestingly, McKinsey found that good investment performance is more important in attracting assets than in retaining them.) "Firms need a specific strategy about what to say when a client calls and wants to withdraw funds," Hunt says. "They need to make the case to stay."
Consultants know all about that.